Industrial ETF’s Pattern Signals a Bearish Play

During earnings season I like to look at the sector ETFs and pay particular attention to the sectors that may have a large number of stocks reporting that week. This process brought my attention to the Industrial Select Sector SPDR (NYSE: XLI). While looking at the XLI, I found that six of the 10 largest holdings in the ETF report earnings between this week and next week.
With over 25% of the S&P 500 stocks reporting this week, it wasn’t surprising to see so many of the industrial stocks on the list. While the earnings reports brought my attention to the XLI, it was something in the chart that really caught my eye. Looking at the daily chart, it looks like the XLI is forming a head and shoulders pattern at this time.
A head and shoulders pattern develops when a stock peaks and forms the left shoulder. It then dips down to form the neckline and then rallies back above the previous peak to form the head. The stock then falls to form the neckline on the other side and then rallies back to a level near the original peak to form the right shoulder.
Looking at the chart for the XLI, we see the left shoulder formed just above $57 in late November. The neckline was formed at the $54 level in mid-December. The head was formed just above $57.50 in late December. The second side of the neckline was created in mid-January and in the last few days the right shoulder was formed.
It is pretty easy to see once it is laid out like I did on the chart, but it isn’t always to see when you are combing through a bunch of charts. The head and shoulders pattern is a bearish pattern and for it to be confirmed, the price will have to drop below the neckline.
In the case of the XLI, a drop below $54 would be confirmation and I believe it could send the ETF down to the low it reached in October at the $48.50 area. Of course the results of the earnings reports will have an impact on whether or not the head and shoulders is confirmed, but the initial reports from Caterpillar (NYSE: CAT) and Lockheed Martin (NYSE: LMT) have been met with skepticism from investors.
The sentiment toward the industrial sector has shifted toward a bullish posture in recent months and from a contrarian viewpoint this is a bearish sign. After options expiration Friday each month, I compile a sentiment composite number on the top ten holdings in each of the select sector SPDR ETFs. The average composite reading for the XLI holdings was 10.64 in December and in January it was 9.1. This represented the fourth-largest shift among the ten sectors.
Given the increasing optimism and the potential to complete the head and shoulders pattern, I would look to make a bearish play on the XLI. You could short the stock or buy short-term puts on the ETF.

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